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Annual McGladrey survey finds sellers of small to mid-market businesses in optimal position

With nearly 50 percent of middle-market companies being private equity-owned, owners of private small and middle-market companies are in an optimal position today if they are considering a sale.

In this highly competitive market, bringing the deal to close with an optimal sale price is paramount. Deal teams are looking for transparency in the process, solid management and leaders in their respective industry.

This assessment is based on findings of an annual survey of 75 managing directors, principals and vice presidents who lead private equity groups investing in the middle market. In the spring of 2011, McGladrey teamed with mergermarket to conduct the independent, third-party survey.

As the domestic market continues to emerge from the recession, many of the responses reflect past-year deals made in a less-than-optimal environment-one in which high-quality companies open to private equity acquisition continued to sit on the sidelines, waiting for the economic tide to turn in order to be rewarded with a better price.

Now in an improving economy, prospective buyers are swarming quality sellers. Private equity groups have capital that is ready for deployment and are exploring exit strategies for their portfolio companies. For many, the investment horizon for generating favorable returns is narrowing. For owners of niche-leading companies, whether private equity-owned or first-time sellers, there is now a window of opportunity for a liquidity event at attractive valuations.

It is a highly competitive environment for private equity firms, as quality sellers are commanding interest from many suitors. “Just because you have cash in your pocket doesn’t mean you should buy the car on the lot you are told is the1 Source: U.S. Census data (1997) best value,” said Don Lipari, national executive director of private equity services for RSM McGladrey. “Savvy shoppers have done their research and sought good advice on both price and fit. They understand what they’re purchasing and the true costs associated with the purchase.”Focus in powerLast year’s McGladrey report on portfolio management showed the tail end of a narrow add-on acquisition strategy that populated the post-crash downturn. Private equity groups are turning the corner and opening their checkbooks, as acquisition operations will be largely centered on platform rather than add-on acquisitions. Sixty percent of respondents reported that they would be spending more than half their acquisition time in 2011-2012 focusing on platform acquisitions.

Amid a more competitive bid environment, buyers appear to be considering industry specialization as a way to set themselves apart from other would-be buyers, with nearly a third of respondents describing their private equity groups as generalists, but saying they intend to narrow their focus on specific sectors.

Costly surprises to consider before striking a deal Advisors are also being hired to work in a once-viewed unnecessary area-pre-letter of intent (LOI) due diligence. With increased competition on the buy-side, exclusivity time has been cut short, if not eliminated, and private equity practitioners are beginning to see the benefit in adding the help of third-party expertise even before signing an LOI.

“It remains a potential battleground for quality platform companies. Private equity firms are in a frenzy to gain position with sellers, making it a dangerous time to be a buyer,” said Hector J. Cuellar, president of McGladrey Capital Markets.

An indication that IT may be underestimated in the deal-making process, respondents stated that management reporting limitations incurred the greatest surprise post-investment costs (47 percent), followed closely by unforeseen capital expenditures (44 percent).

Holding and growing When private equity groups are able to put their stamp on a portfolio company, they tend to be hands-on. Fund managers most frequently make changes to financial reporting, management and human resources, while simultaneously focusing on expansion, acquiring bolt-ons, and introducing new products and services.

Optimizing exitWith the increasing popularity of IPOs as an exit strategy, the majority of respondents agree the time required to make a company IPO-ready is long, with 55 percent reporting that they begin preparing within 18-24 months before the intended IPO. When it came to selling holdings, a third of survey respondents perform sell-side due diligence more frequently than five years ago.

From pre-diligence through exit, private equity groups are modifying their approach to acquiring and managing companies. Some changes are expected and directly reflective of the market dynamics, such as the shift from add-on to platform acquisitions. Others such as the trend toward diligence prior to LIO may evolve into standard practice as buyers focus on optimizing value from the outset. And the drive toward greater operational efficiency will undoubtedly result in greater adoption of practices, such as enhanced reporting across the portfolio and pooled purchasing ranging from raw materials to office supplies to health care. As operating margins continue to compress, private equity executives will evaluate all options to maximize value.

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